The present invention relates generally to the valuation of mortgage-backed securities.
Mortgage-backed securities (MBSs) are popular among investors seeking a fixed-income investment having a yield generally greater than that of U.S. Treasuries or corporate bonds. A MBS is an ownership position in a pool of mortgage loans. Each mortgage loan underlying a MBS may originate in the primary mortgage market with the issuance of a mortgage loan by a loan originator to a mortgagor, typically a homebuyer. The originator may then resell the mortgage loan on the secondary mortgage market for securitization by a government-sponsored enterprise (GSE) such as, for example, Ginnie Mae, Fannie Mae, or Freddie Mac. Securitization refers to the process of MBS creation whereby mortgage loans purchased by, for example, a GSE are grouped into pools based upon loan characteristics, such as, for example, interest rate and time to maturity. Each pool is then divided into ownership shares (i.e., the MBSs) for sale to MBS investors, with each investor receiving a pro rata share of the principal and interest cash flows as the underlying mortgage loans are repaid. MBSs created by a GSE are generally referred to as agency MBSs.
One feature differentiating MBSs from other types of fixed income securities is the risk of prepayment associated with the underlying mortgage loans. In particular, because a mortgagor is typically allowed to prepay their mortgage loan in whole or in part without penalty, a MBS investor must assume the risk that MBS cash flows will be received sooner than anticipated. Prepayment risk depends upon a variety of factors, the most significant being the market interest rate. Generally, the value of a fixed-income investment increases when the market interest rate decreases. The same is true of a MBS, but only to a limited extent. In particular, if the market interest rate decreases below the interest rates of mortgage loans underlying a MBS, some mortgagors may find it financially advantageous to refinance their mortgage loans at the lower market rate. The prepayment of mortgage loans resulting from such refinancing activity forces a MBS investor to re-invest the prepaid amounts at the lower market interest rate, thus decreasing the return on investment. To compensate for this prepayment risk, MBSs typically provide higher returns compared to other fixed-income securities.
MBS valuation methodologies typically model the prepayment privilege as an embedded option written by the MBS investor. Thus, the price of an agency MBS may be stated as the price of an agency bond price less the value of the prepayment option. For MBS investors utilizing these valuation methodologies, the ability to accurately quantify and forecast changes in the prepayment option value is vital for realizing an optimal investment strategy. One known technique for valuing the prepayment option is to decompose a MBS yield curve into its constituent yield components so that the yield attributable to prepayment risk may be analyzed separately from that attributable to non-prepayment risk factors (e.g., the credit quality of the MBS issuer and market liquidity). To perform this analysis, a valuation benchmark curve positively correlated to the MBS yield curve, such as, for example, the swap yield curve or the spread between the swap yield curve and the U.S. Treasury yield curve, may be used as a surrogate for the MBS yield attributable to non-prepayment risk factors. The basis point difference between the MBS yield curve and the benchmark curve (the “prepayment spread”) provides an estimated value of the prepayment option. A widening of the prepayment spread indicates an increasing option value and decreasing MBS price, whereas a tightening of the prepayment spread indicates a decreasing option value and increasing MBS price.
For MBS valuation methodologies currently in use, understanding and predicting changes in the prepayment spread is often based on a qualitative analysis of past prepayment spread changes. Such analysis, however, does not facilitate an understanding of prepayment spread dynamics in terms of one or more current macroeconomic factors and may thus result in a less-than-optimal MBS investment strategy.